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Demystifying Your Debt-to-Income Ratio: Why is it Important?

by iTHINK Financial | Apr 08, 2020

 
Your Debt to Income Ratio is vitalWhen you’re looking to buy a home, there’s a list of things to cross off before you can seal the deal and claim the keys as your very own. From deciding on the perfect location to planning your budget and even buying furniture, the home buying process means taking on a few obstacles before you reach the finish line. 

One of the biggest steps in this process is getting approved for a mortgage loan. As one of the biggest investments you’ll make in your life, lenders want to make sure you’re a qualified candidate for becoming a homeowner. With this comes determining your debt-to-income ratio, otherwise known as DTI. Your debt-to-income ratio is exactly what it sounds like—it measures your debt against your income. 

This means paying bills in a timely manner; having financial stability or even a good credit score won’t necessarily win you a mortgage loan. What will ultimately determine your qualification for a mortgage loan starts with your DTI. But how does one determine their debt-to-income ratio and what can you do to lower it? There are a few things you need to know before you apply for a mortgage and this is one of them.

How is Debt-to-Income Ratio Calculated?

To put it simply, your debt-to-income ratio is all of your monthly debt payments divided by your gross monthly income (in other words, the money you earn before taxes and other deductions are taken out). While the calculation seems simple, there’s a complex layer you should understand before you can accurately determine your DTI ratio, and it comes in the form of two types of DTIs.

Front-End DTI

When lenders look into how much of your pretax income would go toward your mortgage payment, they generally consider your front-end ratio. This number represents how much would go toward housing expenses, including property taxes and homeowner insurance. The average lender prefers that your front-end ratio does not exceed 28%, as anything higher could cause a roadblock in your home buying process.
 

Back-End DTI

The second type of DTI that mortgage lenders use in conjunction to your front-end ratio is called the back-end DTI. Unlike your front-end ratio, the back-end totals all your monthly debts, including expenses such as mortgage payments, credit card payments, child support and other loans, and divides it by your gross monthly income. Generally, lenders look for back-end ratios that don’t exceed 36%, but some are willing to make exceptions for those as high as 50%. You can improve your back-end ratio by selling a financed car or paying off your credit card balances. The lower your debts, the higher the chance of getting approved.

What is a Good Debt-to-Income Ratio?

According to mortgage loan studies, borrowers with a higher DTI are less reliable on meeting monthly payments, specifically those with a DTI ratio of more than 43%. That’s why this is generally the highest ratio a borrower can have and still get a qualified mortgage. 

But according to most credit unions and banks, it’s ideal to have a DTI ratio of 35% or less. This number represents a manageable level of debt and shows that you can still live a comfortable lifestyle even after the bills are paid. That’s why a debt-to-income ratio ranging from 36% to 49% is considered high among most banks, and borrowers are advised to lower this ratio to meet eligibility criteria. Unfortunately, if your DTI ratio is 50% or higher, it’s time to work on consolidating your debt in order to meet those qualification requirements. 

What Does Your Debt-to-Income Ratio Mean?

Even after calculating your debt-to-income ratio, it’s hard to decipher what it means or how much is too much. To make it easy, here’s a general rule-of-thumb to follow. 

DTI of 0% to 14.9%: Paying down your debt isn’t a far-fetched goal for you. With such a low DTI percentage, you can look into a do-it-yourself approach by using the debt avalanche or debt snowball method.

DTI of 15% to 39%: Credit card debt can add up quickly. If this is your primary source of debt, it may be good to look into a debt management plan from a credit counseling agency. If you fall within the higher end of this spectrum, consider a free consultation with a nonprofit credit counselor to understand the next steps in relieving your debt. 

DTI of 40% or more: Seek guidance for your debt relief options. When your DTI reaches this level, it’s not always an easy or pain-free fix. But if you can repay your debts through everyday changes, it should be your first route before resulting to more extreme measures. 

Maintaining a low debt-to-income ratio will give you peace of mind in controlling your finances responsibly. But more importantly, it can help you prepare for future investments like a mortgage. Calculate your debt-to-income ratio today and start taking the steps to lower your DTI. 
 

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